Foreclosed Dreams

Like millions of other Americans, Alicia and Jorge Hernandez are hanging on to their home by a thread. Six years ago they bought their brick bungalow in a working-class neighborhood on Chicago’s southwest side for $175,000, a bargain compared to homes nearby that sold for $250,000. Jorge, who earned $18 per hour as a roofer, had earnestly avoided debt, but a mortgage broker offered him a fixed interest rate of 5.25 percent on a conventional loan. With a growing family, now including three young children, it seemed like a good deal.

Then the housing bubble burst in 2007. On each block throughout the neighborhood, several families – at first mainly those with sub-prime loans – lost their homes to foreclosure. Housing prices fell sharply. The Hernandez home is now worth $119,000, well below the $146,000 still owed on the mortgage. The construction industry imploded and Jorge, 41, could find only scattered jobs. He now collects about $220 per week in unemployment benefits.

“We are a little bit struggling to make our payments,” says Alicia, 39, her voice breaking as she juggles her two-year-old son. ​“We’ve cut out what luxuries we could, like cable. Now we have to decide to continue our lifestyle or cut everything and make the mortgage payments.”

The family ran through its savings, then borrowed from relatives as Jorge’s income continued to slide. But unlike many unemployed workers in past recessions, they had no equity in their home as collateral for temporary credit. Early this year, they fell behind on their mortgage by three months. 

Alicia looked for an administrative assistant job similar to the one she had after college, but nothing turned up. Then she found a job for $8 per hour at a bulk-mailing subcontractor to the U.S. Census Bureau. But even with that paycheck and Jorge’s unemployment compensation, they owe more than half of their monthly income for the mortgage. ​“Like many Americans, we were hoping next year would be better,” Alicia says. ​“We just relied on hope. That was our mistake.”

The Hernandez family is the new face of the deepening home mortgage foreclosure crisis – a crisis that is increasingly affecting suburban and upper middle-income homeowners as well.

In the earlier waves, most foreclosures involved speculators or holders of sub-prime loans that were designed to fail, according to the North Carolina-based Center for Responsible Lending, an advocacy and research organization. Its research shows the fault in the sub-prime collapse lay with the loans, not the people who borrowed the money. Many of them could have qualified for a conventional, fixed-rate mortgage and not defaulted.

Although the new wave of foreclosures this year will involve other exotic mortgages (especially interest-only and payment-option adjustable rate mortgages), most recent serious deliquencies and foreclosures involve conventional loans.

Around three-fifths of homeowners seeking loan modifications under President Barack Obama’s Home Affordable Modification Program (HAMP) cite loss of income as the cause of their hardship. At least one-fourth – and by some estimates one-third, heading toward one-half – of all mortgages are currently ​“under water,” meaning that they are worth more than the market value of the home. Under those conditions, homeowners have strong incentives to walk away, leaving investors holding their costly mortgage and devalued property.

The White House tinkers

Responding in late March to these new trends in the housing crisis, the Obama administration rolled out the latest version of HAMP, which offers new provisions to deal with underwater mortgages and unemployment, some of which might help homeowners like the Hernandez family.

But consumer advocates like the Center for Responsible Lending and the Washington-based National Community Reinvestment Coalition (NCRC) are not happy with the Treasury Department’s proposals. ​“We continue to tinker around the edges of foreclosure prevention,” says NCRC President John Taylor. ​“We rush to give banks tax breaks, but we dawdle to help homeowners.” 

The fundamental problem is that the Obama administration and Congress are reluctant to use the legal, political and judicial forces at their disposal to cut through the Gordian knot of special interests that block meaningful reforms. Instead, banks, investors, mortgage service companies, rating agencies and other financial interests that caused the problem are encouraged and bribed (“incentivized”) to modify troubled loans voluntarily.

Neil Barofsky, the special inspector general for TARP, warns that this scheme ​“risks helping the few, and for the rest, merely spread[s] out the foreclosure crisis over the course of several years, at significant taxpayer expense and even at the expense of those borrowers” who struggle to pay modified loans but eventually default.

Dean Baker, co-director of the Center for Economic and Policy Research, advocates giving defaulting homeowners the option of staying in their homes and renting at market rates for five or more years. Besides keeping people in their homes, the right to rent gives them bargaining leverage with banks to modify loans, since bankers have no interest in being landlords. 

Consumer advocates, such as NCRC, National Peoples Action and the Center for Responsible Lending, fought hard for Congress to give bankruptcy courts the power to modify home mortgages – the only major property excluded from the courts’ oversight. But the proposal was defeated in the Senate, which prompted legislation sponsor Sen. Dick Durbin (D-Ill.) to say the banks ​“own the place.”

With the support of the NCRC, Rep. Brad Miller (D-N.C.) and 26 other congressional Democrats recently proposed that the Treasury use its existing powers to set up an equivalent to the Home Owners Loan Corporation (HOLC), the successful New Deal-era agency. The new HOLC would use the power of eminent domain to buy up large quantities of distressed loans at their current market value, then modify and refinance them. 

Both homeowners at risk of foreclosure and the government need such powerful tools to get deals done quickly and to shift the costs of resolving the crisis to investors and institutions that were responsible. Such cost-shifting could weaken some banks, but oddly, it could also be the best option available – it’s certainly better than foreclosure – in most cases for banks and investors, as well as for homeowners.

Bleeding homeowners

Foreclosure costs both banks and surrounding communities dearly. Valparaiso University Professor Alan White estimates that avoiding foreclosure saves investors more than $50,000 on an average home and avoids external costs – homeowner relocation, depressed neighborhood real-estate values, local government costs – of $100,000 to $150,000.

“Losses to lenders on nonprime foreclosures are as high as 50 percent, yet the pace of modifications remains frustratingly slow,” NCRC’s Taylor testified in March before the House Oversight Committee. ​“It would seem preferable for a financial institution to modify a loan and take a loss of 20 to 30 percent or even 40 percent rather than undergo the considerable costs associated with a foreclosure.”

But many investors or banks hope they can bleed homeowners as long as possible, even though many banks now feel pressure from their growing inventory of distressed loans and the increasing risk of underwater borrowers walking away in strategic default. And they hold out hope for bigger government bailouts, like proposals to pay banks to reduce principal on distressed loans.

Efforts to modify distressed loans started in a modest, ineffective way under former President George W. Bush. The Obama administration has continued to rely on voluntary action by financial interests, and has committed larger amounts of money to support and stabilize home ownership through loan guarantees, purchase of mortgages and mortgage-backed securities, incentives to banks and new homeowners, and its modifying of mortgages through the Making Homes Affordable programs (including HAMP).

An ineffectual solution

But Obama’s programs have had little effect. Last year, foreclosures rose by nearly 2.8 million and experts expect the number to rise again by at least 3.5 million in 2010. (With roughly 7 million homes now in some stage of foreclosure, analysts predict another 13 million foreclosures during the next five years.) Furthermore, as some government props for the housing market come to an end, many analysts expect weak sales and falling prices for many months to come.

Although Obama administration officials said that HAMP would help 3 to 4 million homeowners by 2012, the special inspector general for TARP reported that in its first year, through February, HAMP provided permanent modification to only 168,708 mortgages. Even these ​“permanent” modifications only reduce interest rates and last five years. The Treasury Department expects 40 percent of the permanent modifications to re-default and perhaps face foreclosure within those five years. 

Why is HAMP so ineffective? First, the program’s roll-out was rocky, and the banks and servicers were often slow and disorganized. More fundamentally, says Kathleen Van Tiem of the Southwest Organizing Project, which helps homeowners in the Hernandezes’ neighborhood, HAMP falls short because it uses a flawed financial model to decide which loans to modify. For example, the model overestimates the likelihood that troubled loans will resolve themselves. Further, the model is based on finding the alternative for the loan that is most profitable for investors, not best for the homeowner or community.

Equally important, federal policy does not require anything from mortgage finance world players, who are obscure and plagued with conflicting interests. Holders of second liens on property and principal mortgages were often at odds. Companies (including banks) who were servicing loans often fared worse with modification than foreclosure – while banks holding loans might benefit from modification. Investors in mortgage-backed securities were often splintered and not organized to act at all. Without any mandates, action is stymied.

With unemployment – especially record long-term joblessness – contributing to the rise in foreclosures, government needs to do much more to stimulate job creation, says Baker, especially since the housing sector will not be able to play its traditional role in leading the economy out of recession. Yet reversing the downturn is not enough. In past recessions, there was no spike in delinquencies and foreclosures with increased unemployment. Widespread negative equity and the lingering effects of predatory loans mean that the government must both boost job creation more and restructure mortgages, including guaranteeing borrowers a right to rent. 

Though homeowner advocates lament the loss of $7 trillion in wealth with the housing crash, much of that was bubble money. Trying to prop up home prices below their historic trends helps no one ultimately, says Baker, although he acknowledges that the housing market could overshoot as it deflates as well.

But it is possible for the federal government to help homeowners force banks and investors to absorb more adjustment costs, keep people in their homes (even as renters), protect community interests, and work through the rubble of the busted housing market as rationally and humanely as possible.

For that to happen, the Obama administration, much as it has tried to avoid it, must get tough on the banks and stand up for homeowners victimized by weak regulation, bank deceit and economic collapse. A firm policy that requires financial institutions to reduce mortage principle would combine good economics with winning politics. Many Americans, like the Hernandez family, have been living on hope. Obama needs to redeem those hopes.